The transformation of macroeconomic policy and research prize Lecture, December 8, 2004 by

391

Japan’s Lost Decade of Growth

A more recent example is Japan’s lost decade of growth, which was the

1992–2001 decade. Hayashi and Prescott (2002), treating TFP as exogenous,

find that the neoclassical growth model predicts well the path of the principal

aggregates. In particular it quantitatively predicts the large capital deepening

and the associated fall in the return on capital. It quantitatively predicts the

behavior of labor supply as well, which is further evidence for the high labor

elasticity of labor supply.

A Business Cycle Puzzle

An economic boom in the United States began with an expansion relative to

trend in early 1996 and continued to the fourth quarter of 1999. Then, a 

contraction set in and continued until the third quarter to 2001. At the peak,

detrended GDP per working-age person was 4 percent above trend and labor

supply 5 percent above average. None of the obvious candidates for the high

labor supply were operating. There was no war with temporarily high public

consumption that was debt financed; tax rates were not low; TFP measured in

the standard way was not high; and there was no monetary surprise that

would give rise to high labor supply. This is why I say this boom is a puzzle for

the neoclassical growth model.

Why did people supply so much labor in this boom period? The work of

McGrattan and Prescott (2005a), which determines the quantitative predic-

tions of theory for the value of the stock markets, suggests an answer. The

problem is one of measurement. During this period (see McGrattan and

Prescott, 2005b), there is evidence that unmeasured investment was high, as

was unmeasured compensation. Therefore, output and productivity were higher

than the standard statistics indicate. The measurement problem is to come up

with estimates of this expensed investment. With these improved measure-

ments of economic activity, theory can be used to determine whether or not

the puzzle has been solved.

This example illustrates the unified nature of aggregate economics today.

The real business cycle model was extended and used to understand the 

behavior of the stock market, and that extended model in turn is now being

used to resolve a business cycle puzzle.

8. RAGNAR FRISCH’S VISION REALIZED

I conclude this address with an ode to Frisch, who was awarded the first

Nobel Prize in Economics in 1969. Frisch’s Nobel address is entitled “From

Utopian Theory to Practical Applications: The Case of Econometrics” (1970).

He is the father of quantitative neoclassical economics, which is what he is re-

ferring to by the word econometrics in the title.

14

14 

Frisch (1970, p. 12) reports that the English mathematician and economist Jevons (1835–1882)

dreamed that we would be able to quantify neoclassical economics.

K4_40319_Prescott_358-395  05-08-18  11.41  Sida 391

---

392

Prior to Frisch’s creating the Econometric Society in 1930 and launching

Econometrica in 1933, neoclassical economists did little to verify their theoreti-

cal results by statistical observations. Frisch writes in his Nobel address that

the reason was in part the poor quality of statistics then available and in part

that neoclassical theory was not developed with systematic verification in view.

The American Institutionalists and German Historical schools pointed this

out and advocated letting the facts speak for themselves. The impact of these

schools on economic thought was minimal. To quote Frisch, “Facts that speak

for themselves, talk in a very naive language” (1970, p. 16). Now theory derives its

concepts from measurement, and in turn theory dictates new measurement.

The latter is what McGrattan and I are currently doing to resolve the puzzle of

why U.S. employment was so high at the end of the 1990s.

In the 1960s Frisch was frustrated by the lack of progress in his quest to 

making neoclassical economics quantitative and referred to much of what

was being done then as “playometrics.” It is a little unfair to criticize those 

studying business cycles at that time for not using the full discipline of neo-

classical economics. All the needed tools were not yet part of the economist’s

tool kit. Some of these tools that are crucial to the study of business cycles are

Lindal’s extension of general equilibrium theory to dynamic environments;

Savage’s statistical decision theory as uncertainty is central to business cycles;

Arrow and Debreu’s extension of general equilibrium theory to environments

with uncertainty; Blackwell’s development of recursive methods which are

needed in computation and in representation of a dynamic stochastic equili-

brium; Lucas and Prescott’s development of recursive competitive equilibrium

theory;

15

and, of course, the computer.

Particularly noteworthy is Lucas’s role in the macroeconomic revolution.

In the very late 1960s and early 1970s he revolutionized macroeconomics by

taking the position that neoclassical economics should be used to study busi-

ness cycles. Others had dreamed of doing it, but Lucas actually figured out

ways to do it. In his 1972 paper “Expectations and the Neutrality of Money,”

he creates and analyzes a dynamic stochastic neoclassical model that displays

the Phillips curve, which is a key equation in the system-of-equations macro

models. I can think of no paper in economics as important as this one. The

key prediction based upon this theoretical analysis – namely, that there is no

exploitable trade-off between inflation and employment – was confirmed in

the 1970s when attempts were made to exploit the then perceived trade-off.

But Lucas’s work is not quantitative dynamic general equilibrium, and only

10 years later did Finn and I figure out how to quantitatively derive the im-

plications of theory and measurement for business cycle fluctuations using

the full discipline of dynamic stochastic general equilibrium theory and 

15 

This was further developed in Prescott and Mehra (1980). The published version of “Investment

under Uncertainty” did not include the section formally defining the recursive equilibrium with

policy and value functions depending on both an individual firm’s capacity and the industry 

capacity and was an industry equilibrium analysis.

K4_40319_Prescott_358-395  05-08-18  11.41  Sida 392

---

national accounts statistics. That we have learned that business cycles of the

quantitative nature observed are what theory predicts is testimony to the

grand research program of Ragnar Frisch and to the vision and creative 

genius of Robert Lucas.

On nearly every dimension I am in agreement with what Frisch advocated

in his Nobel Prize address, but on one dimension I am not. Like Frisch, I am

a fervent believer in the democratic process. The dimension on which I disagree

is how economists and policy makers should interact. His view is that the 

democratic political process should determine the objective, and economists

should then determine the best policy given this objective. My view is that

economists should educate the people so that they can evaluate macroeco-

nomic policy rules and that the people, through their elective representativ-

es, should pick the policy rule. I emphasize that Finn and my “Rules Rather

than Discretion” paper finds that public debate should be over rules and that

rules should be changed only infrequently, with a lag to mitigate the time

consistency problem.

REFERENCES

Auerbach, Alan J., Laurence J. Kotlikoff, and Jonathan Skinner. 1983. “The Efficiency

Gains from Dynamic Tax Reform.” Int. Econ. Rev. 24 (February): 81–100.

Brock, William A., and Leonard J. Mirman. 1972. “Optimal Economic Growth and

Uncertainty: The Discounted Case.” J. Econ. Theory 4 (June): 479–513.

Cass, David. 1965. “Optimal Growth in an Aggregate Model of Capital Accumulation.” 

Rev. Econ. Studies 32 (April): 233–240.

Chari, V. V., Patrick J. Kehoe, and Ellen R. McGrattan. 2000. “Sticky Price Models of the

Business Cycle: Can the Contract Multiplier Solve the Persistence Problem?”

Econometrica 68 (September): 1151–1179.

Cole, Harold L., and Lee E. Ohanian. 1999. “The Great Depression in the United States

from a Neoclassical Perspective.” Fed. Reserve Bank Minneapolis Q. Rev. 23 (Winter): 2–24.

Cole, Harold L., and Lee E. Ohanian. 2004. “New Deal Policies and the Persistence of the

Great Depression: A General Equilibrium Analysis.” J. Polit. Economy 112 (August):

779–816.

Cooley, Thomas F., ed. 1995. Frontiers of Business Cycle Research. Princeton, N.J.: Princeton

Univ. Press.

Cooley, Thomas F., and Gary D. Hansen. 1995. “Money and the Business Cycle.” In Frontiers

of Business Cycle Research, edited by Thomas F. Cooley. Princeton, N.J.: Princeton Univ. Press.

Danthine, Jean-Pierre, and John B. Donaldson. 1981. “Stochastic Properties of Fast vs. Slow

Growing Economies.” Econometrica 49 (July): 1007–1033.

Devereux, Michael B., Allen C. Head, and Beverly J. Lapham. 1996. “Monopolistic

Competition, Increasing Returns, and the Effects of Government Spending.” J. Money,

Credit, Banking 28 (May): 233–254.

Diamond, Peter A. 1965. “National Debt in a Neoclassical Growth Model.” Amer. Econ. Rev.

55 (December): 1126–1150.

Fischer, Stanley. 1977. “Long-Term Contracts, Rational Expectations, and the Optimal

Money Supply Rule.” J. Polit. Economy 85 (February): 191–205.

Fisher, Jonas D. M., and Andreas Hornstein. 2000. “(S, s) Inventory Policies in General

Equilibrium.” Rev. Econ. Studies 67 (January): 117–145.

Fitzgerald, Terry J. 1998. “Work Schedules, Wages, and Employment in a General

Equilibrium Model with Team Production.” Rev. Econ. Dynam. 1 (October): 809–834.

Freeman, Scott, and Finn E. Kydland. 2000. “Monetary Aggregates and Output.” Amer. 

Econ. Rev. 90 (December): 1125–1135.

393

K4_40319_Prescott_358-395  05-08-18  11.41  Sida 393

---

Frisch, Ragnar. 1970. “From Utopian Theory to Practical Applications: The Case of

Econometrics.” Lecture to the Memory of Alfred Nobel, June 17, 1970. www.nobelprize.org.

Gomme, Paul, and Jeremy Greenwood. 1995. “On the Cyclical Allocation of Risk.” J. Econ.

Dynam. Control 19 (January–February): 92–124.

Greenwood, Jeremy, Zvi Hercowitz, and Gregory W. Huffman. 1988. “Investment, Capacity

Utilization, and the Real Business Cycle.” Amer. Econ. Rev. 78 (June): 402–417.

Hansen, Gary D. 1985. “Indivisible Labor and the Business Cycle.” J. Monetary Econ. 16 

(November): 309–327.

Hansen, Gary D., and Edward C. Prescott. 2005. “Capacity Constraints, Asymmetries, and

the Business Cycle.” Rev. Econ. Dynam., forthcoming.

Hansen, Gary D., and Thomas J. Sargent. 1988. “Straight Time and Overtime in

Equilibrium.” J. Monetary Econ. 21 (March–May): 281–308.

Hayashi, Fumio, and Edward C. Prescott. 2002. “The 1990s in Japan: A Lost Decade.” 

Rev. Econ. Dynam. 5 (January): 206–235.

Heckman, James J., and Thomas E. MaCurdy. 1980. “A Life Cycle Model of Female Labour

Supply.” Rev. Econ. Studies 47 (Econometrics Issue, January): 47–74.

Hodrick, Robert J., and Edward C. Prescott. 1980. “Post-War U.S. Business Cycles: An

Empirical Investigation.” Discussion Paper 451, Northwestern University, Center for

Mathematical Studies in Economics and Management Science. Published as Hodrick

Robert J., and Edward C. Prescott. 1997. “Postwar U.S. Business Cycles: An Empirical

Investigation.” J. Money, Credit, Banking 29 (February): 1–16.

Hornstein, Andreas. 1993. “Monopolistic Competition, Increasing Returns to Scale, and

the Importance of Productivity Shocks.” J. Monetary Econ. 31 (June): 299–316.

Hornstein, Andreas, and Edward C. Prescott. 1993. “The Firm and the Plant in General 

Equilibrium Theory.” In General Equilibrium, Growth, and Trade II: The Legacy of Lionel

McKenzie, edited by Robert Becker, Michele Boldrin, Ronald Jones, and William

Thomson. San Diego: Academic Press.

Imai, Susumu, and Michael P. Keene. 2004. “Intertemporal Labor Supply and Human 

Capital Accumulation.” Int. Econ. Rev. 45 (May): 601–641.

Kehoe, Timothy J., David K. Levine, and Edward C. Prescott. 2002. “Lotteries, Sunspots,

and Incentive Constraints.” J. Econ. Theory 107 (November): 39–69.

Kehoe, Timothy J., and Edward C. Prescott. 2002. Introduction to “Great Depressions of

the 20

th

Century.” Rev. Econ. Dynam. 5 (January): 1–18.

Koopmans, Tjalling C. 1965. “On the Concept of Optimal Economic Growth.” In Semaine

d’étude sur le role de l’analyse économétrique dans la formulation de plans de 

développement. Pontificiae Academiae Scientiarum Scripta Varia 28, 1.

Krusell, Per, and Anthony A. Smith Jr. 1998. “Income and Wealth Heterogeneity in the

Macroeconomy.” J. Polit. Economy 106 (October): 867–896.

Kydland, Finn E., and Edward C. Prescott. 1977. “Rules Rather than Discretion: The 

Inconsistency of Optimal Plans.” J. Polit. Economy 85 (June): 473–492.

Kydland, Finn E., and Edward C. Prescott. 1982. “Time to Build and Aggregate 

Fluctuations.” Econometrica 50 (November): 1345–1370.

Kydland, Finn E., and Edward C. Prescott. 1991. “Hours and Employment Variation in

Business Cycle Theory.” Econ. Theory 1 (January): 63–82.

Long, John B., Jr., and Charles I. Plosser. 1983. “Real Business Cycles.” J. Polit. Economy 91

(February): 39–69.

Lucas, Robert E., Jr. 1972. “Expectations and the Neutrality of Money.” J. Econ. Theory 4

(April): 103–124.

Lucas, Robert E., Jr. 1976. “Econometric Policy Evaluation: A Critique.” Carnegie-Rochester

Conf. Ser. Public Policy 1: 19–46.

Lucas, Robert E., Jr. 1995. “Monetary Neutrality.” Nobel Prize Lecture, December 7, 1995.

www.nobelprize.org.

Lucas, Robert E., Jr., and Edward C. Prescott. 1971. “Investment under Uncertainty.”

394

K4_40319_Prescott_358-395  05-08-18  11.41  Sida 394

---

Econometrica 39 (September): 659–681.

McGrattan, Ellen R., and Edward C. Prescott. 2005a. “Taxes, Regulations, and the Value of

U.S. and U.K. Corporations.” Rev. Econ. Studies 72 (July), forthcoming.

McGrattan, Ellen R., and Edward C. Prescott. 2005b. “Productivity and the Post-1990 U.S.

Economy.” Fed. Reserve Bank St. Louis Review 87 (July/August), forthcoming.

Pigou, Arthur C. 1927. Industrial Fluctuations. London: Macmillan.

Prescott, Edward C. 1986. “Theory Ahead of Business Cycle Measurement.” Carnegie-

Rochester Conf. Ser. Public Policy 25 (Autumn): 11–44. Reprint, 1986, Fed. Reserve Bank

Minneapolis Q. Rev. 10 (Fall): 9–22.

Prescott, Edward C. 2004. “Why Do Americans Work So Much More than Europeans?” 

Fed. Reserve Bank Minneapolis Q. Rev. 28 (July): 2–13.

Prescott, Edward C., and Rajnish Mehra. 1980. “Recursive Competitive Equilibrium: The

Case of Homogeneous Households.” Econometrica 48 (September): 1365–1379.

Prescott, Edward C., and Karl Shell. 2002. “Introduction to Sunspots and Lotteries.” 

J. Econ. Theory 107 (November): 1–10.

Prescott, Edward C., and Robert M. Townsend. 1984a. “General Competitive Analysis in an

Economy with Private Information.” Int. Econ. Rev. 25 (February): 1–20.

Prescott, Edward C., and Robert M. Townsend. 1984b. “Pareto Optima and Competitive

Equilibria with Adverse Selection and Moral Hazard.” Econometrica 52 (January): 21–45.

Ríos-Rull, José-Víctor. 1994. “On the Quantitative Importance of Market Completeness.” 

J. Monetary Econ. 34 (December): 463–496.

Ríos-Rull, José-Víctor. 1995. “Models with Heterogeneous Agents.” In Frontiers of Business

Cycle Research, edited by Thomas F. Cooley. Princeton, N.J.: Princeton Univ. Press.

Rogerson, Richard. 1984. Topics in the Theory of Labor Markets. Ph.D. thesis, University of

Minnesota, September.

Rogerson, Richard. 1988. “Indivisible Labor, Lotteries and Equilibrium.” J. Monetary Econ.

21 (January): 3–16.

Rosen, Sherwin. 1978. “The Supply of Work Schedules and Employment.” In Work Time

and Employment. Washington, D.C.: National Commission for Manpower Policy.

Rotemberg, Julio J., and Michael Woodford. 1995. “Oligopolistic Pricing and the Effects on

Aggregate Demand on Economic Activity.” J. Polit. Economy 100: 1153–1207.

Solow, Robert M. 1956. “A Contribution to the Theory of Economic Growth.” Q. J. Econ. 70

(February): 65–94.

Solow, Robert M. 1970. Growth Theory: An Exposition. The Radcliffe Lectures, delivered at

the University of Warwick, 1969. Oxford: Oxford Univ. Press.

Stigler, Stephen M. 1978. “Mathematical Statistics in the Early States.” Ann. Statistics 6

(March): 239–265.

Taylor, John B. 1980. “Aggregate Dynamics and Staggered Contracts.” J. Polit. Economy 88

(February): 1–23.

Thomas, Julia K. 2002. “Is Lumpy Investment Relevant for the Business Cycle?” J. Polit.

Economy 110 (June): 508–534.

Wicksell, Knut. 1907. “The Enigma of Business Cycles.” 1953 translation in Int. Econ. Papers

3: 58–74.

395

K4_40319_Prescott_358-395  05-08-18  11.41  Sida 395